Now that you've decided to make contributions to the DCP, you must choose what investment options you're going to use. While this may seem an easy choice - going for the highest return - there are several factors that go into choosing the right type of investment.
Step 1: Determine Your Risk Tolerance
Before you start investing, it's important to determine your risk tolerance. Risk tolerance refers to how much volatility or fluctuation in investment values you can tolerate. If you're 40 and making these contributions, you have a long way to go before you're taking any distributions so you can afford to take some risk. However, if you're making contributions a couple of years out from receiving the income you may not want to expose it to a large market downturn and lose your money before it starts to payout.
Step 2: Understand market risks and how investments in the DCP work
Market risk is the risk you take when you invest in the stock or bond market. Typically, the more risk you take, the higher the potential returns. When people compare a bank CD to investing in small cap companies, the risk is very different but so is the potential return. It's also important to understand that you're not actually investing in specific investments in the DCP - you're just selecting what return you would like credited to your balance each year. For example, if you defer $30,000 in 2024 and choose the investment option of the S&P 500, this $30,000 does not get invested into the S&P 500. Instead, your balance will increase or decrease based on the return of the S&P 500 in set period.
Let's look at an example:
Mark is going to retire in 2032. He defers $30,000 in 2024 and is then looking to defer another $30,000 in 2030. When he retires in 2032, he is having both amounts paid out as a lump sum.
For the amount he defers in 2024, he has eight years until this pays out. In looking at historical returns of the S&P 500, it hasn’t had a negative return over a rolling 8-year time period. If Mark is willing to take the risk of the S&P 500, he'll likely see his $30,000 grow by the time he retires in 2032 and takes the payout.
However, in 2030 when he defers the next $30,000, he only has two years until it pays out. If he were to invest it in the S&P 500, there is a chance that he could lose some of this money in a short term down-market. When it comes to paying out in 2032, he may likely have less than $30,000 if this market situation were to play out.
What do you choose as your investment?
- Understand your timeline – if you’re a long way from retirement, you can afford to take some risks. If it’s just around the corner, play it safe and invest in less risky assets.
- Stay diversified – don’t invest in one type of investment. If something happens in that market, all your deferred money will perform in the same way – either positively or negatively. Spread yourself around various investments to provide a level of diversification in your investments.
- What return do you need? For some, they need to take risk to grow their money to create the largest stream of income. For others, this income stream is part of a large portfolio of investments, and they don’t need to shoot for the moon. Consider this eventual income stream along with your other investments and retirement income. You can then choose how aggressive you want to be as it aligns with other areas of your portfolio.
When you’re looking to invest your DCP contributions, it CANNOT happen in a vacuum. You need to consider the other investments you have, what goals you’re trying to achieve, and your risk profile. If you’d like to chat about what this looks like in your situation, feel free to set up a time on my calendar to chat.